I just finished Robert Hetzel's The Great Recession: Market Failure or Policy Failure. Hetzel is an advocate of what he describes as the monetary view. In this view, the market system will generate real interest rates that maintain full employment of resources in the absence of monetary disturbances. In a modern fiat currency system, monetary disturbances are solely the responsibility of the central bank. By using its ability to avoid monetary disturbances, the central bank can allow the market system to generate real interest rates that maintains full employment.
How is a central bank to avoid monetary disturbances? Hetzel insists that it must create a nominal anchor, and proposes that expected inflation is appropriate. Interestingly, he is critical of the Fed adopting a 2% inflation target rather than promoting price stability. So, with a goal of a stable expected inflation rate of presumably zero, the central bank can then let the actual price level fluctuate according to random shocks. (Presumably these would be supply shocks, but perhaps demand shocks due to errors would also be ignored.) The central bank then changes its interest rate target according to sustained changes in the demand for resources. These adjustments in the policy rate generate real interest rates consistent with full employment of resources.
It sounds a bit like a Taylor rule to me, but Hetzel criticizes the Taylor rule. How is the Greenspanesque sustained changes in the demand for resources different from an output gap? To me, it is the same idea, but I suppose Hetzel sees the output gap as something more concrete. Maybe last quarter's estimate of real GDP less the CBO estimate of potential output. I suppose Hetzel would similarly be critical of using last month's measure of the CPI or CEP to measure inflation. Allowing random fluctuations of the price level in the context of a commitment to a stable price level is also rather Greenspanesque.
Hetzel is very critical of what he calls the credit view, and often adds in the Keynesian view as another equally bad perspective. These views are that the market system is inherently unstable so that central bankers must be given complete discretion to manage the economy. In particular, central bankers must prevent excessive use of debt to fund speculation. If they let that happen, then there is no option but to suffer through a recession to purge all the excesses. Hetzel provides plenty of evidence that that Fed caused the Great Depression as an unintended byproduct of its effort to curb excess credit to fund stock market speculation. And then, allowed the economy collapse, treating it as the unavoidable consequence of that prior speculation. Further, it aborted recovery due to worries of excessive credit funding too much speculation. As for Keynes, Hetzel sees worries about fluctuations in the animal spirits of investors as being the same foolishness in another guise.
Hetzel argues that fractional reserve banking isn't especially unstable. He is very concerned with the moral hazard created by bailouts. He certainly grants that insolvent banks are subject to runs, and depositors that expect to be bailed out will fund banks that are poorly-capitalized and take excessive risks. But in a regime where banks depositors don't expect bailouts, banks are less likely to become insolvent. And when conservatively-managed, well-capitalized banks do become insolvent, it is those banks that suffer runs, not all banks.
Hetzel builds a convincing case that Friedman and Schwartz were mistaken in blaming bank runs for the severity of the Great Depression. According to Hetzel, a monetary disturbance caused the Great Depression, and only as the Great Depression made banks insolvent, were they subject to runs. Rather than the Bank of United States failing, and all the ignorant depositors at other banks withdrawing their funds, bank runs only occurred gradually, here and there, with very specific solvency problems developing.
Hetzel draws parallels between the credit view during the Great Depression, and the credit views of the Great Recession. He rejects the notion that excessive credit to fund speculation in housing caused the Great Recession. Instead, he blames the failure of the Fed to reduce interest rates in the face of economic weakening in 2008 largely due to worries about rising oil prices. In Hetzel's view, shifts in oil prices should be allowed to cause the price level to change,. These are the permitted "random" fluctuations in the price level in the context of a long run commitment to stable prices. The policy rate should have been reduced because of the sustained reduction in the demand for resources.
As for the financial crisis, he explains that as being due to discretionary changes in expected bailout policy. If financial markets had always been based upon making debtors take losses, there would have been no problem. No financial panic and not very many insolvencies. If the "bailout everyone" policy had been continued, there could have been insolvencies of reckless and poorly-capitalized financial firms, but no financial panic. It was the discretionary approach of first bailing out Bear Stearn and then not bailing out Lehman Brothers that caused the financial crisis. Still, the Great Recession wasn't caused by that crisis. And the Fed's focus on fixing financial markets did little good. The problem was the monetary disturbance--failure to adjust the policy rate so avoid sustained changes (decreases) in the demand for resources, in the context of a long run commitment to stable prices.
In my view, Hetzel should take the next step. He should adopt nominal GDP level targeting as a proposed rule. While the credit view may be wrongheaded and worries about animal spirits overdone, the only way these could cause generalized shifts in the demand for output is by impacting the quantity of money or the demand to hold it. These are perhaps wrongheaded theories of what causes monetary disturbances. And all monetary disturbances have monetary solutions. As a practical matter, keeping nominal GDP growing on a targeted path in the face of credit-fueled speculation, deleveraging, or changes in animal spirits is the least bad option.
Hetzel does mention sometimes that the Fed should be focusing on increasing or maintain spending on output. But it is almost like reading Milton Friedman. There are hints, but it in the end, the rules are about the price level. Take the leap. Target the level of spending on output--nominal GDP.
Hetzel insists that the market should generate a real interest rate to maintain full employment. If think he focuses too much on interest rates. While adjusting a policy interest rate according to changes in the demand for resources does seem like a way of getting at the appropriate interest rate, it is hardly market determined. Of course, other interest rates--particularly longer term to maturity ones--would be market determined. And admittedly, there may be no better alternative. Adjusting the quantity of base money according to the demand to hold it is difficult too. As Hetzel mentions, estimating money demand is not easy. (Hetzel doesn't discuss his proposal to target expected inflation as calculated using TIPs, much less index futures targeting as proposed by Sumner.)
Even in the extreme case, where the shadow equilibrium real interest rate on hand-to-hand currency is negative, the problem is still monetary. The argument shouldn't be that in the absence of monetary disturbances, the equilibrium interest rate on all financial instruments, no matter how short or safe, will always be positive. It is rather that the only way these sorts of problems caused general gluts of goods is because they lead, either directly or indirectly, to a shortage of money. And fixing such shortages of money (and avoiding surpluses) is the key role of a monetary regime.
Thursday, July 5, 2012
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